What really happened in Cyprus: My interview with Athanasios Orphanides, former central bank governor

Greg Ip, at The Economist, closes with this Q&A:

What will the implications be for Europe and the stabilization of the euro zone?

This is similar to the blunder in Deauville with PSI that injected credit risk into sovereign government debt. The governments have created risk in what before last week were considered perfectly safe deposits. This is going to have a chilling effect on deposits in any bank in a country perceived to be weak. This will mean the cost of funding will increase in the periphery of Europe and as a result, the cost of financing for businesses and households will increase. That will add to the divergences we already have and make the recession in the periphery of Europe deeper than it already is. This is really a disaster for European economic management as a whole

This is by far the best explanation of what has happened in Europe. Read the whole thing.


A simple point about capital controls

More on Capital controls via Tyler Cowen

John Dizard writes:

Capital controls turn into trade controls, as the locals attempt to find ways to turn hard assets or non-banking services into foreign exchange. At some price, for example, you can buy a boat in Cyprus with post-haircut, capital-controlled local deposits, sail it to Lebanon, and then sell it for real, usable money. The same with antiques, jewellery, or anything else you can think of. Even capital goods such as fork lifts can be motored off in the middle of the night.

Here is a long Cardiff Garcia post on capital controls, excellent throughout.  From Garcia, there is also this:

Reinhardt, Rogoff and Maduff did a meta-analysis in 2011 on prior studies of capital controls. The only uncontroversially (though mildly) successful use of controls on outflows they found was Malaysia in the aftermath of the Asian financial crisis. Even then, the controls were accompanied by aggressive counter-cyclical spending, bans on short-selling the currency and trading it offshore, and defending the ringgit against speculators by fixing it to the dollar.

One wonders – did the Eurogroup read Reinhardt, Rogoff and Maduff?

Fed Watch: Do Capital Controls Mean Cyprus Has Already Left the Eurozone?

(…)  If I can spend my dollar in Oregon but not in California, it is really the same dollar? I think not.

 Is this how the Eurozone experiment will end? Not with a formal “exit,” but with a return to banking dominated by national boundaries and enforced by capital controls? No longer a true common currency, but a dozen currencies sharing the same name, each with a different value?

There will be another banking crisis in Europe (just as a bank will fail in some US state) and depositors are now aware that they are fair game in any crisis response, so capital flight will intensify at an earlier stage in the crisis. As may have been noted, European policymakers find rapid crisis resolution to be something of a challenge, thus accelerated capital flight will necessitate a more rapid imposition of capital controls in the future – and with each round of capital controls, a new sub-euro will be born.

Bottom Line: Europe’s response to the Cyprus situation will have long-lasting impacts on the Eurozone experiment itself, none of the good. Indeed, the imposition of capital controls should lead one to wonder if the “solution” to Cyprus is effectively an exit from the Eurozone is everything but name. And don’t forget that the crisis also threatens to destabilize the region geopolitcally. I don’t think that “disaster” is too strong a word in this case.

Looks like the answer is yes – but the EU elites don’t have to formally recognize the exit.

Euro: the potential feedbacks are scary

Italy’s public debt hit an all-time high in June of almost 2 trillion euros and the annual budget deficit was also bigger than a year before, due largely to Italy’s share of bailouts for other euro zone states, the central bank said on Monday.

I’m not confident that this analysis is correct, but it sure bears consideration. There are some scary feedbacks that can excaberate the stresses of the periphery:

…This is why the monetary side is so critical. If both Spain and Italy move from the ranks of the bailing out to the bailed out, the fiscal burden on the rest of the euro area rises, pushing other members toward crisis.

Simon Johnson on the Euro

John Cochrane recommended Simon’s essay here. I recommend that you read Simon with breakfast, but definitely do not read before bed.

Simon Johnson has a good blog post on the end of the euro. Digging in, the run is on, the end is near, and the chaos will be worse than you thought. The ECB has also monetized a lot more than you thought.

Still, I do not understand why even Simon cannot imagine the idea of sovereign default while staying in — and firmly committing to stay in — the currency union. The picture Simon paints of the euro breakup is a catastrophe. So why not even talk about sovereign default (restructuring) without euro breakup?

It strikes me as really the only way out, and the longer Europe waits, the harder it will be.